Shell Is First Major to Take a Charge on Sour U.S. Shale Oil

Is it just Royal Dutch Shell (RDS.A)? Or has the U.S. shale oil boom started to run into problems as promises outrun performance?

As expected the company's problems with its investments in natural gas from North American shale generated a gusher of red ink when the company reported results for the June quarter yesterday. Hit by low prices for natural gas in the United States, and higher costs for production and exploration, the company reported a drop in profits to $4.6 billion from $5.7 billion a year earlier.

The real shocker, though, was the news that the company would write down the value of its shale oil assets in North America by $2.1 billion. Shell's strategy for making up for lower natural gas prices had been to refocus its shale efforts on producing oil and other liquids from this region rather than continuing to expand natural gas production.

Now that strategy looks to be in question and that's a big deal. Several other oil companies (such as BHP Billiton (BHP)) have written down the value of their U.S. natural gas from shale assets, but Shell is the first major to take a big charge on disappointing performance from oil production from U.S. shale.

Shell has been one of the most aggressive investors among the international majors in U.S. shale resources. For example, in 2008 the company paid $5.7 billion to buy Duvernay Oil and its shale positions in western Canada. In 2010 Shell paid $4.7 billion for East Resources and its positions in the Marcellus shale region. The company now owns about 3.5 million acres of leases in North American shale regions.

None of which has worked out especially well. For the trailing 12 months to June 2013, Shell's shale operations generated $2 billion in losses, according to Morningstar.

The solution to this problem, the company announced in 2012, was that it would shift its shale investments and production activities from natural gas to liquids. The goal, the company said, was to produce 250,000 barrels of oil a day from its shale resources within five years.

But that effort isn't exactly roaring ahead. Production today from these resources is running at just 50,000 barrels a day.

The problem seems to be that not all shale resources are equally easy to exploit. Marginal areas are characterized by less porous rock, which makes it harder and more expensive to extract oil and natural gas. The oil and natural gas may be under less pressure -- again making it harder and more expensive to extract.

And finally, many marginal geologies are more fractured with smaller regions of gas and oil shale separated by larger deposits of non-producing rock. It's clear at this point that prime formations such as Eagle Ford in Texas of the Bakken in North Dakota are much more productive at much lower costs than formations such as Ohio's Utica.

That's bad news for Shell, which looks like it overpaid for some less than prime resources, but it also raises an important question for investors in the industry as a whole. How big is the drop off in production and the climb in expenses outside prime shale geologies and how far do these prime geologies extend before they start to show lower production and higher costs?

Sector analysts have begun to grapple with evidence showing that production from shale resources declines more quickly than from conventional resources. Combating that requires drilling more wells with closer spacing. That's more expensive, but drilling costs for experienced shale operators are also falling, creating a race between more drilling and falling costs per well. Now Shell may have introduced another factor into the analysis -- the question of how big a difference there is in production and costs between prime and marginal shale resources.

It's going to take a while for this to make it into analysts' models. While it does, I'd suggest sticking to operators concentrated in the Bakken, Eagle Ford, and other prime resources.